Defined benefit plans and cash balance plans are excellent retirement strategies. They work great for high-income taxpayers who are looking for substantial tax deductions.
But can you purchase life insurance and a defined benefit or cash balance plan? Yes, you can. But it requires careful plan structuring and coordination with tax and financial professionals.
This article will discuss the current tax issues relating to this plan structure. I will also point out a few tips along the way so you can keep your distance from the IRS. Let’s dive in!
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Some Background
When you purchase life insurance in a qualified plan, the premium itself is paid with pre-tax funds. Said differently, you get a current tax deduction for the premiums paid while the insurance is in the plan.
However, the IRS requires the participant to recognize the economic benefit received as taxable income. This recognized amount varies annually and is generally calculated by subtracting the policy cash value from the death benefit.
This taxable value is also called the economic benefit. It is the personal benefit of the insurance received that is determined by taking the lower of the IRS Table 2001 cost or simply the life insurance company’s determined cost for an individual, standard-rated one-year term policy. In theory, this is straightforward.
Suppose you retire or you decide to terminate the plan. In that case, the policy can be purchased and transferred to an irrevocable life insurance trust (ILIT), simply transferred to the insured, surrendered with the remaining cash value residing in the plan. Alternatively, it can be sold to the insured or even a grantor trust adopted by the insured party.
If the insured dies prematurely, the life insurance policy’s beneficiaries receive the death benefit, less any cash value in the policy, income tax-free. Any taxable economic benefit the participant pays while still alive can be recovered from the cash value tax-free.
At what point is life insurance taxable?
Any remaining cash value can continue to remain in the qualified plan or be taxed as a plan distribution. But any death benefit paid from the insurance policy in a qualified plan must be included in the decedent’s estate for both federal and state estate tax purposes.
Employees and business owners alike face the challenge of accumulating sufficient assets to provide for their needs in retirement. They often turn to qualified retirement plans (or “Qualified Plans”1 ) as a tax efficient means of providing retirement benefits.
But employees and business owners face another problem: What happens to their families if they die before reaching retirement age? Death benefit coverage provides for family members what retirement savings give to employees and owners.
| Pros | Cons |
|---|---|
| Flexible Funding Range | Mandatory Contribution Levels |
| Tailored Plan Design | High Set Up Costs |
| Tax-Deferred Contributions | IRS Permanency Rules |
| Easy Rollover to IRA | No Employee Deferral Choice |
And so employees and business owners often ask: Would it be more efficient to provide death benefit protection using the same dollars being used to provide retirement benefits? If so, can money which is contributed to Qualified Plans be used to purchase life insurance?
The election of a life insurance benefit within a qualified plan is deemed to be a current plan benefit and is treated similarly to employer-provided group life insurance. The value of the current protection is determined using a government table, Table 2001, or a life insurance company’s alternative term rates if available.
Plan participants essentially pay the tax on a term insurance rate for the current life insurance protection rather than paying tax on the actual permanent life insurance premium. The rates applied are a standard rate available to all insureds and ignore smoking status and substandard rating charges.
Qualified plan basics
Above all, qualified plans are designed to accumulate assets for retirement, since:
- Contributions are tax-deductible to the employer plan sponsor.
- Contributions are tax-deferred to the employee participant.
- Growth in qualified plan values are tax-deferred for the employee participant.
- Plan assets are generally sheltered from creditors.
When the plan permits, purchasing life insurance within a qualified plan can be
an excellent means by which business owners can leverage pretax dollars while
protecting their beneficiaries and assets.
Tax Treatment of Current Life Insurance to the Qualified Plan Participant
When life insurance is purchased inside a qualified retirement plan, the plan participant enjoys current life insurance protection in addition to the other benefits provided.
According to the IRS, this benefit has an economic value subject to income taxation. Consequently, qualified plan participants must include in gross income each year the cost of life insurance protection (or the “economic benefit”) for the death benefit provided under the plan.
A participant in a qualified retirement plan must include in income the cost of life insurance protection for insurance held by the plan if the proceeds are either payable to the participant’s estate or beneficiary or are payable to the plan’s trustee, and the plan requires the trustee to pay the proceeds to the employee’s estate or beneficiary. The economic benefit is measured based only on the cost of the “pure amount at risk” – i.e., only the net death benefit above the policy’s cash value is used to determine the taxable cost of life insurance protection.
1099-R Issuance
The cost of life insurance protection is determined by applying a 1-year premium term rate for a person of the insured’s age to the difference between the face amount of insurance and the cash surrender value at the end of the year.
In most cases, the appropriate 1-year premium term rate will be found in “Table 2001,” which was first published by the IRS in Notice 2001-10 and then re-published in Notice 2002-8. Until further guidance is issued, it may also be possible to utilize the one-year term rates published by the insurance carrier that issued the policy held in the qualified plan.
According to IRS guidance, an insurance carrier’s rates may be substituted for the rates prescribed under Table 2001 if the insurer has a one-year term product available to all standard risks, the insurer generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer, and the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurer’s normal distribution channels.
Example: Participant’s qualified plan holds a life insurance policy insuring the participant’s life, and the death benefits are payable to participant’s estate. At the end of the year, the participant is 45 years old. The policy has a face amount of $300,000 and a cash surrender value of $50,000. The Table 2001 1-year premium term rate for a 45-year-old is $1.53 per $1,000 of insurance protection. Participant must recognize $382.50 of income for the cost of life insurance protection [((300,000 – 50,000)/1,000) x 1.53 = 250 x 1.53 = 382.50].
What is a qualified retirement plan?
A qualified plan is a certain type of retirement plan that meets the Internal Revenue Code (IRC) requirements. As such, it is eligible for certain tax benefits. Employers typically offer these plans to help their employees save for retirement.
There are two main types of qualified retirement plans: defined benefit plans and defined contribution plans.
A defined benefit pension plan is a retirement plan that promises to pay a specific amount of retirement income to the employee based on a formula that considers factors such as the employee’s salary and years of service. The employer is responsible for funding the plan and assumes the investment risk.
On the other hand, a defined contribution plan is a retirement plan structure that allows employees to contribute a specified portion of their wages to the plan, which is then invested. Examples of defined contribution plans include 401(k), 403(b), and profit-sharing plans. In most cases, the employer will also contribute to the plan on behalf of the employee.
One of the key benefits of a qualified retirement plan is that contributions are tax-deductible, which can help reduce an individual’s taxable income. Additionally, earnings on contributions grow tax-deferred until they are withdrawn in retirement, at which point they are taxed as ordinary income.
Various rules and regulations govern qualified retirement plans, including contribution limits, vesting schedules, and distribution requirements. Employers and plan administrators are responsible for ensuring their plans comply with these rules to maintain their qualified status and associated tax benefits.
